What Is a Hedge?

Hedging is a strategy to limit investment risks. Investors hedge an investment by trading in another that is likely to move in the opposite direction. A risk-reward tradeoff is in🐭herent in hedging; while it reduces potential risk, it may chip away at potential gains.

How a Hedge Works

Using a hedge is a bit like taking out an insurance policy. If you own a home in a flood-prone area, you can protect it from the risk of flooding—hedge it, in other words—by taking out flood insurance. Yo🌳u cannot eliminate the risk of a flood, but you can mitigate the financial losses you c🏅ould incur.

Similarly, if you invest in a hot technology company with the firm belief that its business will thrive over the next quarters, you might also invest in a solid consumer staple stock just in case you're mistaken.

The Downside to a Hedge

Hedging isn’t ♓free. In the case of the flood insurance policy example, the monthly payments add up, and ✨if the flood never comes, the policyholder gets nothing. Still, most people would choose to limit their losses.

In the world of professional investing, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their 澳洲幸运5官方开奖结果体彩网:risk exposure. They use various to𝓰ols for the purpo💖se, many based on derivatives.

Hedging With Derivatives

Derivatives are financial contracts 🎃whose price depends on the value of an underlying security. Futures, forwards, and options contracts are common types of derivative c💛ontracts.

The effectiveness of a derivative hedge is expressed in terms of its delta, sometimes called the hedge ratio. Delta is the amount that the price oꦑf a derivative moves per $1 movement in the price of the underlying asset.

🌺 The specific hedging strategy, as well as the pricing of hedging instruments, depends largely upon the downside risk of the underlying security against which the investor wants to hedge. Generally, the greater the downside risk, the greater the cost of the hedge.

Downside risk tends to increase with higher levels of volatility and over time; an option that expires after a longer period, which is linked to a volatile security, will be more expensive as a means of hedging.

In general, the higher the strike price, the more expensive the put option will be, but the more price protection it will offer as well. These variables c🌳an be adjusted to create a less expens𒀰ive option that offers less protection, or a more expensive one that provides greater protection.

Example of Hedging With a Put Option

A common method for hedging is through put options. Puts give the holder the right, but not the obligation, to sell the underlying security at a pre-set price on orဣ before the date it expires.

For example, if Morty buys 100 shares of PLC stock at $10 per share, and hedges the investment by purchasing a 澳洲幸运5官方开奖结果体彩网:put option with a 澳洲幸运5官方开奖结果体彩网:strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of that stock for $8🍰 per share anytime in the next year.

Let’s assume Morty pays $1 for the option, or $10🅠0 in premium. If the s🃏tock trades at $12 one year later, Morty will not exercise the option and will be out $100:

• $1,000 for the stocks and $100 for the option = $1,100
• Stock appreciates to $1,200
• $100 lost by not exercising the option
• But gains $100 ($1,200 - $1,000 paid for stock - $100 paid for option)

If the stock price fell to $0, ꧒Morty would exercise the option and♚ sell the shares for $8, for a loss:

• $1,100 for stocks and the option
• Sold shares for $800
• Total loss of $300

Without the option,⛄ Morty would have lost the entire investment of $1,000.

Hedging Through Diversification

Strategically 澳洲幸运5官方开奖结果体彩网:diversifying a portfolio to reduce certain risks can also🌳 be c🍸onsidered a hedge. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.

Thi🍒s strategy has its tradeoffs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring countercyclical stocks, which might fall as capital flows to m💃ore exciting places.

It also has its risks: Tꦐhere is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis.

Spread Hedging

For investors in index funds, moderate price declines are quite common and highly unpredictable. Investors focusing on this area may be more concerned with moderate declines than severe ones. In these cases, a 澳洲幸运5官方开奖结果体彩网:bear put spread is a common hedging strategy.

In this type of spread, the index investor buys a put that has a higher strike price. Nex꧙t, they sell a put with a lower strike price but the same expiration date.

Depending on how the index behaves, the investor has a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a moderate amount of protection, 𓃲it is often sufficient to cover a brief downturn in the index.

Hedging and the Everyday Investor

Most individual investors don't trade derivative contracts. Investors with a long-term strategy, such as those saving for retirement, can ignore the day-to-day fluctuations of the markets.

For investors who fall into the buy-and-hold category, there may seem to be little or no reason to learn about hedging. Still, because large companies and investment funds tend to engage in hedging practices regularly, and because these investors might follow or even be involved with these larger financial entities, it's useful to understand what hedging entails to comprehend the actions of these larger players.

The Bottom Line

Hedging is an important financial concept that allows investors and traders to mi𝓡nimize various risk exposures. A hedge is effectively an offsetting or opposite position taken that will gain (or lose) in value as the primary position loses (or gains) value.

A hedge can be thought of as a type of insurance policy on a🐲n investment or a portfolio. These off🍸setting positions can be achieved using closely related assets or through diversification.

📖Among professional trade💞rs, the most common and effective hedge uses derivatives such as futures, forwards, or options contracts.